The indexes that are bridging the gap between active and passive investing

Algorithmic indexes are attempting to bridge the gap between active and passive investing, but can the two approaches really merge? And will fans of active strategies be persuaded that passive investing is the way forward? Clare Dickinson reports from the Art of Indexing conference in New York

New York: location of the Art of Indexing event

The debate over whether passive or actively managed investment strategies bring the best value to investors has waged for years but with algorithmic indexes being launched by banks and index providers, the line between the two has become blurred. The next step could be an index of actively managed strategies, as was discussed at the Art of Indexing Conference in New York on October 27 2010.

Index-linked investments have taken off in a big way, with the exponential growth of the exchange-traded fund (ETF) business, which is now a trillion dollar global industry.

With the proliferation of passive investments comes the danger that some will be less efficient than others and that mistakes will be made, as Russell Wild, investment advisor from Global Portfolios in Great Neck, New York discussed during his breakfast briefing.

While extolling the virtues of ETFs, such as tax efficiency and low costs, Wild warned against several mistakes which can lead to getting it wrong. Among his list was following the crowd, "chasing what's hot" and "investing in nonsense", an example of this was the HealthShares Emerging Cancer ETF, he said, which is no longer trading on exchange.

Wild also noted that investors need to be aware of the different levels of fees for ETFs, saying that there are 103 ETFs trading in the US which charge fees of more than 2%. Although they are passive investments, he advised that they need monitoring and that portfolios need to be rebalanced every year to 18 months.

In response to a question from the floor about actively managed ETFs, Wild said he was "sceptical of asset management" and that investors have to "apply more due diligence with active products".

Actively managed ETFs first came to market in 2008 and have been slow to make their mark but they follow a trend towards a merger between active and passive investments. Christopher Carosa, chief contributing editor of Fiduciary News in Monroe County, New York spoke about this market move to find a solution between the two strategies.

Rather than seeing an index-linked investment as passive, Carosa reminded those in the room that indexes themselves are to some extent actively managed, someone chooses what goes into the index and it is rebalanced on a regular basis. "We should get rid of the idea of passive investment. We should see the index as an actively managed portfolio," he said.

Despite the now popular belief that passive investments perform better because they have less costs involved, Carosa said that even in the so-called ‘Lost Decade' of 2000-2010, eight out of 12 mutual funds made money and he said that "throughout the 2000s the index fund market doubled, but with all the losses we might have lead them [investors] off a cliff".

Carosa continued to talk about returns generated by actively managed funds over the past 34 years, saying that half the time active strategies beat passive strategies, including fees.

This was contested from the floor by Wild who said that surely the average actively managed fund will perform averagely but with added fees, which a passive fund does not have. Carosa's response was that the statistics from Morning Star and Lipper suggest that show that actively managed funds have beaten passive funds 50% of the time.

But instead of looking at a rigid split between the two, he concluded that the meaning of the word ‘index' needs to be redefined. "An index of active managers may seem impossible but people said that about the S&P 500 40 years ago so some day we will see one."

Speaking on the conference sidelines after the presentation, Carosa continued the idea of a convergence between the two investment strategies. "With passive investments you know what you are getting, with active you know there is some chance you will do better than average. I think you should look at a way to do both. If people can find a way to flip between both they will have a major product," he said.

Dynamic indexes are a first step toward that, he said that before the end of the decade he expects to see actively managed indexes. The problem would be how to achieve that with a transparent index. "If you are required to expose your strategy then anyone will be able to construct the portfolio."

Carosa explained that the Securities and Exchange Commission (SEC) requires quarterly reporting of investment portfolios but it is delayed on purpose so that people cannot copy the strategy. However, he said that he does not think transparency is that important, "what you are doing with transparency is analysing the underlying, that is the only advantage... I don't think it matters. In an actively managed fund we buy a person. With an index fund you want it to track the index."

The debate about active versus passive continued in the conference sidelines. Seddick Meziani, professor of finance and economics and Montclair University in New Jersey and chairman of the conference, said that the preference for an active or passive fund should depend on the underlying market which an investor wants access to. With a developed market there is so much information about the market that it is hard to outperform the market, he said. With an emerging market, there is "not enough information so someone can outperform there because of the inefficiency".

Konrad Sippel, head of sellside business and executive director at Stoxx in Eschborn, Germany, was surprised to see this age-old debate revived. However, he agreed with Meziani's view that it depends on the underlying and said that he can see a mergence of the two investing strategies. "Passive is following the active, for example dividend strategies. We have had active asset managers providing out performance with simple dividend selection. People look at doing that as a passive investment. Now you can have a passive product based on a dividend strategy."

In his morning presentation, Serge Troyanovsky, head of retail distribution North America for the structured solutions group at BNP Paribas in New York introduced the bank's Millennium Long/Short Commodities Index as a third generation index. It uses an algorithmic index to change its investment strategy depending on market movements. It is an index, which is traditionally thought of as passive, but it involves an active strategy to try to beat the benchmark. In his performance graph, Troyanovsky demonstrated the outperformance of the Millennium Commodities Index against the S&P GSCI, Dow Jones AIG and the Rogers International Commodities Index.

He explained the investment story behind the index: "Commodities came on the horizon five to 10 years ago and there is increased use. It protects against inflation and there is the idea that they are de-correlated with equities but there is no easy way to access commodities."

The index provides an easy way to do this but the next step is how to deliver the index to clients, he said. The bank is looking into an ETF but it can also be wrapped into a note. But as always, the issue of cost was high on the audience's agenda and there was a question about what it costs to maintain the index. Troyanovsky responded that as BNP Paribas is a large player in commodities, the lending costs for rebalancing the portfolio are not very high.

Charles Aram, chief executive of Henderson Rowe in London also spoke about a different type of passive investment in his afternoon presentation. Aram discussed the FTSE Rafi Index series, which selects index components based on fundamentals such as total cash dividends, free cash flow, total sales and book equity value.

He said that the market cap weighted index is based on the assumption that markets are efficient and if that is true they cannot be beaten. But he warned that cap-weighted indexes overweight the overpriced stocks and underweight underpriced stocks.

By using a different weighting system the Rafi series avoids this and it works well in a growing market, however, in a bear market it will not outperform market cap indexes, explained Aram.

But even with these new strategy indexes, active management will be preferred by some, as Stoxx's Sippel noted "it is there to stay, people will always look for outperformance".